During the last few decades, many emerging markets have lifted restrictions on cross-border
financial transactions. The conventional view was that this would allow these countries to: (i)
receive capital inflows from advanced countries that would finance higher investment and growth;
(ii) insure against aggregate shocks and reduce consumption volatility; and (iii) accelerate the
development of domestic financial markets and achieve a more efficient domestic allocation
of capital and better sharing of individual risks. However, the evidence suggests that this
conventional view was wrong.
In this paper, we present a simple model that can account for the observed effects of financial
liberalization. The model emphasizes the role of imperfect enforcement of domestic debts and the
interactions between domestic and international financial transactions. In the model, financial
liberalization might lead to different outcomes: (i) domestic capital flight and ambiguous effects
on net capital flows, investment, and growth; (ii) large capital inflows and higher investment
and growth; or (iii) volatile capital flows and unstable domestic financial markets. The model
shows how these outcomes depend on the level of development, the depth of domestic financial
markets, and the quality of institutions.